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Multi-Asset Portfolios - CIOs’ investment strategies: Q&A

Q1 / What are the key themes for multi asset investing in 2018, and how should investors play them?

We believe that in 2018 the key themes for multi-asset investing will remain broadly the same as in 2017, but with a different tilt and different implications on asset allocation. Central bank asynchrony will continue to unfold, with the Fed (and the BoE) on the tightening side, and the BoJ and ECB still broadly accommodative, but with adjustments likely. Therefore, investors should continue to reduce spread duration while maintaining credit exposure for carry trade reasons, and keeping average government bond duration short. In credit, investors should focus on IG vs HY, with a preference for the eurozone while it is still supported by the ECB’s purchasing programme. We think inflation will be a key theme for 2018 amid a market that is sceptical in its expectations and commodity prices on a mildly rising trajectory. For us, this means favouring real vs. nominal rates with a focus on Japan, US and European inflation linkers. Another important theme we have identified is the paradigm shift (from monetary to fiscal policy). Regarding this, we believe investors should see more inflation catalysts to further increase the commitment to the performance laggards (Europe) that seem more sensitive to yield curve steepening. In Europe, financials could still offer opportunities, as the sector could benefit from the lack of interest rate steepening on the continent. A commitment to Japan should be maintained, with a progressive move towards a more selective approach in order to reflect the partial closure of the valuation gap and a positioning strategy which is less exposed than a few months ago. On EMs, we continue to see as beneficial a country-specific approach to identify stronger vs. weaker players and to take advantage of the different macroeconomic transition speeds. In our opinion, playing the entire EM complex seems like a potential mature trade in the presence of a strengthening USD and the perspective that rates will likely increase. Among EMs, we have positive views on South Korea and Russia given the backdrop of a solid macroeconomic situation. China is a theme investors should keep playing with a dual approach: as a relative value story, playing the progress of internal reforms and economic rebalances (New China vs Old China sectors), and given a directional focus, being aware of the increasingly stretched valuation conditions arising from the 2017 rally and macroeconomic variables that look to have peaked already but that remain supportive. We would suggest remaining liquid on quality names in EM bonds, preferring, when possible, carry trades in FX EM which look to be a more liquid proxy vs. cash bonds.

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Q2 / What are the major changes that multi-asset investors should apply to their 2018 strategy compared to 2017 and why?

We believe investors should more intensively play country/sector/style and asset class/approach rotation during 2018. On style and sectors, we would focus on a rotation back to value in case of positive inflation and term structure evolution (steepening). On asset classes, we would look at a rotation towards equity vs. HY, which is experiencing a leverage increase back to 2008 levels and now appears vulnerable to interest rate rises (especially in the US). In terms of investment approach, we would focus on a rotation towards relative value trades to exploit different speeds in economic and policy adjustments, with a stronger focus on measures to tame rising volatility, liquidity and credit risk.On equity, our strategy would mean progressively replacing cash equity with an asymmetric option strategy, where we are keen to give up some participation in exchange for more protection.

Q3 / What are the main issues/events to watch during the year and why?

We think one of the key variables to look at will be US short-term real rates (see chart). This variable is extremely important as a barometer for the correct functioning of a leveraged credit market (HY more than IG in the US) and of equity markets. The US equity market has been largely driven so far from buybacks that seem to dry up when credit markets experience difficulties.

Outside the US, we believe it will be important to monitor producer price index (PPI) dynamics in EMs – more specifically, in China – because they can help in understanding price dynamics in DM as well. We monitor EMs’ equity resilience, which critically depends on the level of the US dollar and ample liquidity.

Q4 / In your view, what are the biggest opportunities and risks not priced into the market for the new year?

In this last phase of 2017, a wave of limited inflation printing and cautiously dovish news from central banks have to a large extent favoured a further flattening of yield curves, preventing real rates from continuing to see a rising trend. Oil prices have been rising, but without noticeable effects on inflation expectations as measured by breakeven rates. In this environment, some equity markets, such as those in Europe, which are highly exposed to financials and industrials, have slowed more vs Japan and the US. European equities and financials specifically can deliver positive surprises if and when a mild but steady reflation process will be back in focus, driving the long end of the yield curve higher. We expect this to be in focus in 2018 with an increasing likelihood of seeing a transition to a late cycle. Among the risks not priced in by the markets, we would mention liquidity and credit risk.

These are clearly connected to each other, and both are associated with very low volatility. Structural changes in liquidity providers with banks deleveraging their balance sheets are largely untested, with investors’ portfolios still extremely long income-seeking positions. A faster-than-expected increase in real rates could generate a market selloff in a fragile environment in which risks and asset classes will likely prove closely interconnected.

Q5 / And what strategies should investors apply to mitigate risk in 2018?

A rise in volatility from extremely suppressed levels seems likely in a year of contractions in central bank balance sheets and rising rates (the Fed). We expect to see a resurgence of liquidity as well as – especially in the US – credit risk. To mitigate this risk, investors could use different strategies: raise the liquidity profile in their portfolios; improve the average credit rating; maintain a commitment to a risk on stance, but progressively adopt option structures rather than cash equity; implement hedging strategies.
On hedging strategies, we believe that gold could work well when real rates dynamics give mixed signals regarding asset reflation vs the late cycle. The AUD/YEN could prove to be an efficient hedge if China were to start showing signs of a slowdown in growth and a PPI reversal. We would continue to play the USD/EUR as a safe haven in case of a market selloff or to counter geopolitical risks. We believe that at the current level of spreads and leverage, some hedging strategies on US HY spreads could be helpful in case of a market selloff.Leveraging on the outcome of our Internal Risk Survey that compares the probability of occurrence and the impact on the implemented strategies, we believe investors should hedge the following risks: